Lec 7 - The Business Cycle, Inflation & Deflation Flashcards
Business cycle definition
Fluctuations of real GDP around potential GDP.
Increase in potential GDP (whether due to labour, technology, capital) brings expansion.
Inflation cycle definition
Fluctuations of price level.
Business cycle approaches
What are the two main approaches to understanding business cycle theory?
Two approaches to understanding business cycle theory:
Mainstream business cycle theory
Real business cycle theory
Mainstream business cycle theory
Because potential GDP grows at a steady pace while aggregate demand grows at a fluctuating rate, real GDP fluctuates around potential GDP.
Within mainstream business cycle theory, there are different views as to why this is the case: the monetarist view is that AD grows at a varying pace because of money supply.
Business cycle with AS-AD
What happens if AD increases more slowly than potential GDP?
During an expansion, aggregate demand increases and usually by more than potential GDP.
Assume that during this expansion the price level is expected to rise and that the money wage rate was set on that expectation.
The price level rises as expected.
But if aggregate demand increases more slowly than potential GDP, the AD curve shifts to AD2.
Real GDP growth is slower; inflation is less than expected.
Business cycle with AS-AD
What happens if AD increases more quickly than potential GDP?
If aggregate demand increases more quickly than potential GDP, the AD curve shifts to AD3.
Real GDP growth is faster; inflation is higher than expected.
What does the relentless increase in potential GDP cause?
Economic growth, inflation and the business cycle arise from the relentless increase in potential GDP, faster (on average) increases in aggregate demand, and fluctuations in the pace of aggregate demand growth.
Causes of business cycles and recessions
One point of contention among economists is the causes of business cycles and recessions.
And if you disagree on the causes, chances are that you disagree on the solutions.
Real business cycle theory
Random fluctuations in productivity are the main source of economic fluctuations.
Productivity fluctuations are assumed to result mainly from fluctuations in the pace of technological change.
Other sources: international disturbances, climate fluctuations or natural disasters.
RBC impulse = productivity growth rate
Most of the time, technological change is steady.
But sometimes productivity growth speeds up, and occasionally it decreases.
RBC impulse definition & effects
A period of rapid productivity growth brings an expansion, and a decrease in productivity triggers a recession.
There are two effects which follow a change in productivity that gets an expansion or a contraction going:
Investment demand changes.
The demand for labour changes.
RBC impulse - effect of productivity on investment
A decrease in productivity decreases investment demand, which decreases the demand for loanable funds.
The real interest rate falls and the quantity of loanable funds decreases.
The decision of when to work
To decide when to work, people compare the return from working in the current period with the expected return from working in a later period.
The when-to-work decision depends on the real interest rate.
The lower the real interest rate, the smaller is the supply of labour today.
Many economists believe that this intertemporal substitution effect is small, but RBC theorists believe that it is large and the key feature of the RBC mechanism.
Effect of a decrease in productivity on demand for labour
Figure shows the effects of a decrease in productivity on demand for labour.
A decrease in productivity decreases the demand for labour.
The fall in the real interest rate decreases the supply of labour.
Employment and the real wage rate decrease.
RBC criticism and defense
The money wage rate is sticky, and to assume otherwise is at odds with facts.
Intertemporal substitution is too weak a force to account for large fluctuations in labour supply and employment.
Paul Krugman argued that this assumption would mean that 25% unemployment during Great Depression (1933) would be the result of a mass decision to take a long vacation.
RBC theory explains facts about the business cycle and is consistent with economic growth.
RBC theory is consistent with a wide range of microeconomic evidence about labour supply decisions, labour demand and investment demand decisions.
Cause of inflation
What is the cause of inflation in the long run and short run?
In the long run, inflation occurs if the quantity of money grows faster than potential GDP.
In the short run, many factors can start an inflation, and real GDP and the price level interact. We distinguish two (short run) sources of inflation:
Demand-pull inflation
Cost-push inflation
Demand-pull inflation definition
Demand-Pull inflation may begin with an increase in any factor that increases aggregate demand (AD), such as: quantity of money, government expenditure, exports.
Cost-push inflation definition
Cost-Push inflation results from an initial increase in costs: money wage rate, money price of a raw material (oil).
Demand-pull inflation in practice
What is the initial effect of an increase in Aggregate Demand?
Starting from full employment, an increase in aggregate demand shifts the AD curve rightward.
The price level rises, real GDP increases and an inflationary gap arises.
The rising price level is the first step in the demand-pull inflation.
Money wage rate response to demand-pull inflation
The money wage rate rises and the SAS curve shifts leftward.
The price level rises and real GDP decreases back towards potential GDP.
As the money wage rate continues to rise, the SAS curve shifts further leftward.
Real GDP decreases back to potential GDP but the price level rises further.
Demand-pull inflation spiral
Aggregate demand keeps increasing and the process just described repeats indefinitely.
Although any of several factors can increase aggregate demand to start a demand-pull inflation, only an ongoing increase in the quantity of money can sustain it.
Cost-push inflation
What is the initial effect of a decrease in aggregate supply?
A rise in the price of oil shifts the SAS curve leftward.
Real GDP decreases and the price level rises.
The rising price level is the start of the cost-push inflation.
Aggregate demand response to cost-push inflation
The initial increase in costs creates a one-time rise in the price level, not inflation.
To create inflation, aggregate demand must increase.
That is, the Bank of England must increase the quantity of money persistently.
The Bank of England might stimulate demand.
The price level rises again and real GDP increases.
Cost-push inflation spiral
If the oil producers raise the price of oil and the Bank of England responds with an increase in aggregate demand, a process of cost-push inflation continues.
Stagflation definition
The combination of a rising price level and a decreasing real GDP.
Expected inflation
Aggregate demand increases, but the increase is anticipated, so its effect on the price level is expected.
It can thus be factored in to the wages.
Forecasting inflation
To anticipate inflation, people must forecast it.
The best forecast available is one that is based on all the relevant information and is called a rational expectation.
A rational expectation is not necessarily correct, but it is the best available.
Forecasting inflation - effect of different outcomes
When the inflation forecast is correct, the economy operates at full employment.
If aggregate demand grows faster than expected, real GDP moves above potential GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demand-pull inflation.
If aggregate demand grows more slowly than expected, real GDP falls below potential GDP, the inflation rate slows, and the economy behaves like it does in a cost-push inflation.
Misery Index
Low inflation, low unemployment and rapid income growth is ideal.
In the 1970s, when inflation was raging at a double-digit rate, Arthur M. Okun proposed a Misery Index:
Misery Index = inflation rate + unemployment rate
Limitations of misery index
What are the four main limitations of this model?
There are a number of limitations of this model:
Arguably UK unemployment is underestimated.
Deflation is worse than inflation. Therefore, inflation of 0% may suggest a stagnant economy like Japan in the 1990s, but gives a low misery index.
Inflation may be temporary, e.g. due to cost push factors.
Costs of unemployment arguably greater than inflation – it depends on factors like real interest rates which determine real value of savings.
Life satisfaction and misery index variables
Inflation and unemployment are not equal. Unemployment is more detrimental to happiness than inflation.
Phillips curve definition
A curve that shows the relationship between the inflation rate and the unemployment rate.
Short run Phillips curve
The relationship between inflation and unemployment, holding constant:
The expected inflation rate
The natural unemployment rate
Long run Phillips curve
The relationship between inflation and unemployment when the actual inflation rate equals the expected inflation rate.
Short run Phillips curve in practice
It passes through the natural unemployment rate and the expected inflation rate.
With a given expected inflation rate and natural unemployment rate:
If the inflation rate rises above the expected inflation rate, the unemployment rate decreases.
If the inflation rate falls below the expected inflation rate, the unemployment rate increases.
Long run Phillips curve in practice
The Long-run Phillips curve (LRPC) is vertical at the natural unemployment rate.
Along the long-run Phillips curve, because a change in the inflation rate is anticipated, it has no effect on the unemployment rate.
Phillips curve in practice - changes in expected inflation rate
Short-run Phillips curve shifts when the expected inflation rate changes.
A lower expected inflation rate shifts the short-run Phillips curve downward by an amount equal to the fall in the expected inflation rate.
Phillips curve in practice - changes in natural unemployment rate
A change in the natural unemployment rate shifts both the long-run and short-run Phillips curves.
